The Benefits of Diversification
There are different approaches to diversification in the investment world. One school of thought is that diversification is really “de-worse-ification.” The thought is that all your money should be put in your best investment ideas. Why invest in your 15th best, 20th best, or even 50th best idea? You can find investors and fund managers who’ve used this approach and have lots of success stories.
What you don’t hear about is how this approach can be dangerous. What happens if your best idea turns out to be wrong? Investors don’t usually publicize their failures, but that doesn’t mean there aren’t any. I’ve known experienced, Ivy League-educated managers who apprenticed under well-known, well-respected, successful managers who essentially blew up their fund because they were overly concentrated. Some popular mutual funds with great long-term track records have followed the “best idea only” school of thought. They have put almost a third of their fund in one stock or group of similar stocks and have lost money over the past five years while the market was up significantly!
No one can accurately predict the future. Sometimes there are many warning signs about a big stock that blows up. General Electric has had well-publicized problems for years. Short sellers and critical journalists (sadly, there aren’t many left these days) raised serious questions about companies like Enron and Valeant Pharmaceuticals before they blew up. Other times serious things occur that no one could have foreseen or investors could never know.
Clients depend on us to shepherd and grow their money for retirement. No one person or group of people is omniscient. We’d rather err on the side of caution and over-diversification (if there is such a thing).
Take the latest news with Boeing, for example. The modern commercial passenger aviation industry is incredibly safe. It’s highly unlikely anyone could have predicted that two 737 Max jets would crash only a few months apart under similar circumstances. (Yes, we are aware of some of the tertiary issues regarding pilot complaints and the wisdom of 737 Max designs.). Of course, Boeing stock has taken a hit.
We own Boeing stock, and guess what? Our two stock portfolios are doing well and outperforming the market. In fact, even if Boeing stock went to zero, both of our portfolios would still be outperforming. That’s the value of having a diversified portfolio.
We constructed one section of our portfolio around the trend that global travel is increasing and consumers are putting more emphasis on travel and vacation experiences. Our investment challenge was to expose our clients to this winning investment idea while minimizing risk.
Buying every travel-related stock probably isn’t a great idea. Airline stocks have historically been terrible investments because the companies operate in brutally competitive environments with very high expenses. Rental car companies like Hertz also aren’t great investments. The rental car business is extremely capital intensive, brutally competitive, and returns on capital and profits are low.
There are, however, other good (in our opinion) companies. In addition to Boeing (BA), we own the following stocks that are linked to air travel:
- Rolls-Royce (RYCEY) – a manufacturer of jet engines
- Booking Holdings (BKNG) – an online travel agency, operating primarily in Europe
- Hexcel (HXL) – a supplier of advanced composite materials to Airbus and Boeing
Excluding Boeing’s defense contracting business, we have about 4.8% (more in our concentrated portfolio) of a client’s individual stock portfolio devoted to these four companies. If something happens to any one company it won’t be big deal. We also want to limit the total amount of the portfolio devoted to any one “theme.” What if another 9/11 happens and travel comes to a halt? If so, less than 5% of a client’s portfolio is at risk.
Strubel Investment Management’s approach to diversification is to make our client portfolios as robust as possible while minimizing risk. We are enjoying the benefits of that idea with what is currently happening with Boeing. We’ve done similar things in other areas of the portfolio.
For example, we have slightly more than 3% of the client portfolio devoted to the four big US defense contractors (Lockheed Martin, Northrop Grumman, Raytheon, and the defense portion of Boeing). The loss of any one contract to a company won’t be a big deal. If say the Democrats take control in 2020 and reduce defense spending, then only 3% of the client portfolio is at risk.
We have a little more than 4% of any portfolio devoted to the construction/remodel sector. We own Sherwin-Williams (the architectural coatings business in the US has only three major competitors), A.O. Smith (the water heater business has only two competitors in the US), and Lennox International (again the HVAC industry is heavily consolidated).
Another example is the cable company Charter Communications. As more people ditch their cable subscription and move to streaming, Charter benefits immensely. High speed data customers have much higher profit margins than video cable customers. Additionally, there is little to no competition for high speed data in many of the markets Charter serves. What about 5G? If 5G takes over then Charter faces competition from AT&T and Verizon. Without getting into detail, we think that is unlikely. But, even if it happens, that’s OK. We own two cellphone tower leasing companies: American Tower Corp and SBA Communications. Our thesis is that wireless companies are going to spend a lot of money on 5G, but the service won’t be good enough or cost effective enough to rival wired broadband internet so owning both Charter and the cell tower companies is beneficial.
It’s not always possible to buy a basket of companies. Sometimes only one or two companies control an industry. There’s only one Google for example and only one publicly traded NBA team (Madison Square Garden, owner of the NY Knicks). In those cases, we have a higher percentage of our portfolio in those stocks.
I hope that these examples illustrate the benefits of diversification. Sure, returns won’t be as high as funds that put 10%, 15% or even 30% of their portfolio in one stock. Our goal, however, is to responsibly shepherd our clients to retirement and not turn their portfolios into a casino.